It appears investors are putting money into banks in the belief the banks are safe because governments can be relied upon to bail them out the next time they get into trouble. These investors could be right.

It’s not so much that banks are too big to fail, it is more that they are too important to let fail.

Banks are essential in creating the money supply. When banks make a loan they create money and the total money supply is increased.. When the loan is repaid, the money supply decreases until the money is re-loaned and the supply goes back up. Thus the money supply is constant – until a central bank purchases government bonds. Because the central bank pays for these bonds by adding to the liabilities of its balance sheet, this is the creation of new money. But because of fractional reserve requirements (banks are required to hold a percentage of deposits in reserve against withdrawals) money created by the central bank is called high powered money and the money supply goes up with a multiplier effect.

All this is explained in any textbook on the economics of money and banking. What I have never seen explained is the effect on the money supply when a bank writes off a loan. Probably it has the reverse effect of high powered money – a decreased money supply subject to the same multiplier. (Here is a link to the wikipedia article on money creation.)

In most cases the writing off of loans will have little effect on the money supply However, if the amounts to be written off are large as was the case with the American housing crisis or is likely to be the case with any sovereign debt write off, the impact on the money supply will be substantial and it we lead to an abrupt decline economic activity. People will invent alternatives to the lost money but the initial devastation will be a problem.

The Americans are considering cutting back on their food stamp program. My prediction is that when the next financial crisis happens, keeping the banks going will come before feeding people.

Let’s end this post with the following quote attributed to Henry Ford.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

(This is an update of a post originally published in June, 2011.)

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One Response

You are correct in that there seems to be a lot of people who have studied the way banks and lending help, when things are going well, but very little concern about the potential damages when things go wrong. One of the things that I find most interesting about the recent financial collapse is this: in 2005 and 2006 the total number of failed banks was 0. Not a single bank failed in those two years. I was thinking about this and came up with the question: how many years has this happened? I looked at the failure rate of banks, as published by the FDIC, and found that in 80 years 2005/2006 were it. It makes me sound pessimistic but how could no one have noticed that too much success might lead to catastrophe? I really wish there was similar data leading up to the Great Depression because my guess would be that there was a similar trend there as well. I suppose this isn’t as much about the effects of failure within the markets but more an indicator that a failure is possible.

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